*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)

This Week’s Options Insight

Every day, option traders all over the world haggle over what each trader believes is a fair premium based upon their individual prediction of future stock prices. The haggling has gone on ever since the invention of options, but it wasn’t until fairly recently, somewhere around 1993, that someone had the idea to reverse engineer the process and interpret the results.

If predictions about future stock prices determine option premiums, then an analysis of option premiums should reveal traders predictions. When an analysis of options was performed on the stocks in the S&P 500, the result was a prediction that is now known as the VIX (CBOE Market Volatility Index).

Since 1993 the popularity of the VIX has grown. For those traders not yet acquainted with the VIX, it is simply a statement of the expected range of the S&P 500. For example, a VIX of 20 indicates a prediction that the level of the S&P will be within a range of 20% higher to 20% lower than it is today, exactly one year from now.

Volatility can be a somewhat complex subject, but there is a simple formula that can be useful for most traders: Volatility is generally about half as much when the period of time is reduced to one quarter of the original. For example, if the S&P is expected to be within a range of plus or minus 20% a year from now, then it would be expected to be within a range of plus or minus 10% a quarter of a year, or three months, from now. Continuing the process, the expected range would be plus or minus 5% three weeks from now, and plus or minus 2.5% five days from now.

The VIX is widely publicized, especially when it changes significantly. But, reports of the accuracy of the predictions implied by the VIX are much less common. For example, if the VIX was 20 three months ago, that would imply a trading range today of the S&P of +/-10% from the S&P’s level at that time. If in fact the S&P was trading 15% above the level of three months ago, that would indicate an inaccurate prediction by the VIX, but such an inaccuracy would likely go unnoticed. It is the prediction that tends to interest folks, not the outcome.

To be fair, the VIX does not make a blanket prediction, but rather places conditions on the forecast, not unlike a weather forecast. As an example, a VIX of 20 would imply a 70% chance that the S&P would be within 10% up or down, three months in the future. So, technically the VIX is not flawed if the S&P ends the period with a gain of 15%. But it surely doesn’t paint a picture of the VIX having a good handle on the future.

When the VIX fails, or stated more accurately, when the S&P experiences low-probability outcomes as predicted by the VIX, that should be a heads up for traders. After all, who creates the VIX? Traders do, through the bid and ask prices on their option trades. And who causes the S&P to experience an improbable outcome that flies in the face of the VIX? Traders do. That seems a bit hypocritical. When traders have difficulty predicting how they themselves will be trading, that can be an important warning sign of an unpredictable market. The VIX has failed quite a bit in recent weeks and months, so traders really need to stay alert now.

The following analysis is part of a weekly options analysis that seeks to evaluate the accuracy of past predictions of the VIX. This is accomplished by analyzing different types of option trades, all of which have premiums that are highly correlated with the VIX. Accuracy and inaccuracy of trader’s predictions, as revealed by option trade performance, allows traders to gain insight into the stock market. When the VIX is a hypocrite, there are lessons to learn.

You Are Here – Bull Market Stage 1

The market is currently in Bull Market Stage 1. This stage is characterized by failure of the VIX to be a good predictor. Stock prices have climbed much higher, much faster in recent months than would be expected as a probable outcome given the level of the VIX at the time. The implication for traders is that the pace of the current uptrend is unsustainable. Furthermore, the pace has been unsustainable for quite some time, 16 weeks and counting, and one of the longest unsustainable trends in the past 10 years.

If the S&P was to fall below 1621 this week (ending Jun. 23, 2013) it would mark a transition from an unsustainable uptrend, to one that is more reasonable, more in line with the predictions revealed by past levels of the VIX. It would mark the end of Stage 1 and the beginning of Stage 2.

A level above 1621 would suggest that the party isn’t over just yet, and that the unsustainable uptrend is still in place, at least temporarily.

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in control of the market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

This week, Covered Call trading and Naked Put trading were both profitable, as they have been for an extended period. That means the Bulls remain in control. The reasoning goes as follows:

• “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.

• “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.

• “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

This week, Long Call trading and Married Put trading were both profitable. Both forms of trading became profitable in late January. It means the Bulls are not only in control now, but they are confident and strong. The reasoning goes as follows:

• “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.

• “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears overstepped their authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames. Most important is the profitability of these trades opened 112 days prior to expiration.

Long Straddle trading and Long Strangle trading became profitable on March 1, 2013. Since then, each trading strategy has continued to profit, and has reached historically rare levels of profitability on several occasions.

An elevated LSSI has always led to a correction in the past, and there’s no reason to suspect this time will be an exception. It’s just a matter of how long until it occurs. The reasoning goes as follows:

• “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.

• “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

• “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

Questions, comments and constructive criticism are always welcome. Enter them in the comment box below, or send them to OptionScientist@zentrader.ca.

The preceding is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book “Show Me Your Options!”